The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
With so much going on in the global economy and financial markets, the dollar’s strong recent appreciation has attracted less attention than what would have been expected given the historical experience.
On paper, the appreciation of the currency of the world’s most resilient economic performer should help adjustments in the global economy. It helps boost the exports of weaker countries while alleviating inflationary pressures in the US by lowering the cost of imports.
But in current conditions, there are hazards in a rapid rise in the dollar for both the wellbeing of an already wobbly global economy and for unsettled financial markets.
Since the start of the year, the dollar has appreciated by some 10 per cent as measured by DXY, a widely-followed index of the currency’s global value. In what has been a notably broad move encompassing the currencies of the vast majority of economies, the total 12-month appreciation of 16 per cent has taken the index to levels not seen for 20 years.
Three factors are in play: expectations that the US Federal Reserve will raise interest rates more aggressively than other central banks in the advanced world; US economic outperformance that attracts capital from the rest of the world; and the relative haven appeal of its financial markets.
So far there has been little political pushback to a development that erodes US competitiveness and contributes to its record trade deficit. In the past, such rises in the dollar have threatened trade wars. Now America’s strong labour market has countered potential tensions.
Yet the lack of US political antagonism over the dollar’s ascent does not mean that it’s smooth sailing for global economic and financial stability. The risks are particularly acute for those developing countries already facing the clear and present dangers of crises over the economy, energy, food and debt.
For most of them, dollar appreciation translates into higher import prices, more costly external debt servicing and greater risk of financial instability. It puts further pressure on countries that already stretched in resources and policy responses by the fight against the ravages of Covid.
The concern is particularly acute for low-income countries hampered also by high food and energy inflation. A cost of living crisis here is also a threat of famine for the most vulnerable ones.
If allowed to burn further, what I have called the “little fires everywhere syndrome” — that is, multiplying country cases of economic and financial instability — can merge into a bigger, more dangerous combination of damaged global growth, debt defaults, and social, political and geopolitical instability.
The spillbacks to the advanced economies are potentially more problematic than any direct effect on them of dollar appreciation. In addition to weakening the external growth engines of such economies at a time of growing stagflation at home, a destabilised developing world can add volatility to financial markets that are already dealing with multiple risks.
Financial markets already had to navigate a significant increase in interest rate risk owing to the persistently high inflation that has caught the Federal Reserve massively offside. In the process, the disruptions to government bonds spread to other market segments as the concerns over tightening financial conditions started to mount. Now markets have to worry more about slowing global economic growth.
As unpleasant as the wealth destruction has been this year, its impact on economic activity has been muted and the risk of market functioning has yet to kick in. Having said that, for those with sharp noses, there is already some scent of this owing to the crypto carnage, together with repeated price gapping in the US Treasury market’s global benchmarks.
Even if this were to develop into something bigger because of payments disruptions in the developing world, the Fed would find it tricky to revert to its usual policy of flooding the markets with liquidity given its bloated balance sheet and inflationary concerns.
The way to reduce the risks associated with too rapid a dollar appreciation is for the rest of the world to progress faster with structural reforms that enhance growth and productivity, improve returns on capital and increase economic resilience.
Without that, the theoretical promise of an orderly global adjustment, including external boosts for underperforming countries, would become a challenging source of economic and financial instability.